Academic journal article Economic Inquiry

Finance and the Sources of Growth at Various Stages of Economic Development

Academic journal article Economic Inquiry

Finance and the Sources of Growth at Various Stages of Economic Development

Article excerpt


The effects of financial development on economic growth have been widely discussed in the academic literature. The increased availability of financial instruments and institutions reduces transaction and information costs in an economy. Larger and more efficient financial markets help economic agents hedge, trade and pool risk, raising investment and economic growth. (1) The hypothesis that finance increases growth has been tested in various ways, mostly finding a significant positive effect. (2) However, there are two issues that have received less attention: first, whether finance affects growth in different ways in industrial versus developing countries, and second, how financial development affects the sources of growth. (3) Although there have been some studies of these two issues separately, they have not been analyzed in a unified fashion as perhaps they should be given some recent theoretical work.

Specifically, Acemoglu et al. (2002) show that a developing country that is behind the technological frontier will typically pursue a capital accumulation growth strategy ("investment-based growth"). At this development stage, there is less incentive to be highly selective of firms and managers because this is costly. Hence, we observe long-term business relationships between financial market agents and firms, which result in funds flowing to those established firms for capital accumulation purposes. Conversely, industrial countries that are at the technological frontier have a strong incentive for innovation, so they are very selective of firms and managers that can attain this goal. Financial markets will then fund these innovation activities leading to larger productivity gains ("innovation-based growth"). (4)

Further theoretical support is found in Lee (1996), who models a process of learning-by-doing in which lending decisions improve over time as lenders acquire project-specific information by making investment decisions. Again, this points to more efficient allocation of funds, which go to the most productive firms in developed economies (see also Acemoglu and Zilibotti [1997]).

Hence, as financial markets are crucial to fund production-related activities, we may observe a differential effect of financial development--not only on economic growth but on the sources of growth based on a country's relative position. We propose to empirically test the following propositions:

* Does financial development have a larger effect on capital accumulation in developing countries than in industrial countries?

* Does financial development have a larger effect on productivity growth in industrial countries than in developing countries?

Our article closely follows Beck et al. (2000) in estimating the effect of financial development on the sources of economic growth. We extend their analysis by exploring whether those effects differ in systematic ways depending on the level of economic development of a country. We use a large panel data set of 74 countries that covers the 1961-95 period. Furthermore, we apply generalized method of moments (GMM) dynamic panel techniques to deal with the possible simultaneity of financial development and economic growth and to control for country-specific effects. Our results are consistent with previous empirical work that finds that the effects of finance on economic growth may vary in different types of countries. (5) Our results go further finding that finance has a strong positive influence on productivity growth primarily in more developed economies. Conversely, in less developed economies, the effect of finance on output growth occurs primarily through capital accumulation and not productivity.

The remainder of the article is organized as follows. Section II discusses the measures and data; section III describes the methodology. Section IV presents and discusses the results, and section V concludes. …

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